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 While the liftoff for rates is likely a year or more away, Fed
officials already have devoted a lot of thought to the mechanics of
how they pull off that move.
It's a delicate issue for the central bank.
The Fed has flooded the financial system with $3.4 trillion, and
$2.6 trillion of that has ended up back at the Fed as excess bank
reserves. With that much money of their own, banks have little need
to borrow from each other in the federal funds market to meet the
Fed's daily reserve requirements.
As a result, the market has lost some relevance and liquidity,
causing a few Fed officials to reconsider the idea of reverting to a
specific federal funds rate target any time soon.
"My view is it would be perfectly appropriate potentially in the
early part of the interest-rate hike period to just move that range
up, and recognize that at least for a while it's going to be hard to
hit a specific number," San Francisco Fed President John Williams
told reporters last week in Dallas.
And even though since December 2008 the target for the federal funds
rate has been a range of between zero and 0.25 percent, rather than
a specific figure, most primary dealers who deal directly with the
Fed still expect the Federal Open Market Committee to raise it back
to a single number when the time comes, according to Reuters polls.
They may be surprised then should the Fed choose not to abandon the
range just yet, as some like Williams have suggested.
The Fed's first rate increase may well be to a range of perhaps 0.25
percent to 0.50 percent instead of a jump to say 0.50 percent,
according to Williams, who will be a voter on the FOMC next year
when the rate-rise question will be front and center.
To be sure, some other Fed officials still prefer a single target
for the fed funds rate for clarity and ease to guide the market. It
also makes easier for traders who use the fed funds rate as a
benchmark for other short-term rates and derivatives.
In addition to being the rate banks charge each other for overnight
loans to meet the Fed's reserve requirements, the fed funds rate is
an important reference point used to determine other borrowing
costs, such as the prime rate, which banks charge their most
creditworthy customers.
If a higher rate range is adopted and ends up confusing the market,
it could disrupt overnight lending markets, hurt the Fed's
credibility and harm the economy, analysts said.
"The mechanics of policy tightening is still a tricky issue for the
Fed," said Millan L. Mulraine, deputy head of U.S. research and
strategy at TD Securities in New York.
This quandary on setting rate targets seems part of a broader policy
debate within the Fed whether it should abandon the fed funds rate
altogether.
Dallas Fed President Richard Fisher said this month "the fed funds
rate is not the right tool going forward" given the others
available. That echoes a high-profile paper co-authored by Brian
Sack, the former New York Fed markets chief, that suggested a new
tool known as overnight fixed-rate reverse repurchase agreements
should supplant fed funds as the Fed's primary policy tool.
BUILDING A RATE CHANNEL
Policy-makers appear confident that the Fed could guide overnight
borrowing rates higher at increments the market can absorb by
establishing a channel between the rates set by two new tools,
interest on excess reserves at the top end and overnight reverse
repos as the floor.
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They could decide on such an approach during one of the next few
policy-setting meetings, in June, July or September, analysts said.
Continuing with a target range could have several advantages for the
Fed.
For one, it would allow for more flexibility on where the bank
allows the rate to settle on any day or during any period between
the policy meetings when it sets the target.
Whereas establishing a single-point target would entail the Fed
striving to keep the daily effective rate at or at least very close
to that rate, a range would permit it to offer a little more
accommodation or slow the pace of increase if conditions warranted.
Since the Fed established the zero to 0.25 percent range
five-and-a-half years ago, the fed funds effective rate, determined
daily by the New York Fed, has settled at the very top of that range
on just two occasions. For the most part it has moved between 0.09
percent, where it is now, and 0.18 percent, depending on financial
conditions.
A range may be easier to control, too, which is important for the
Fed's credibility. As they were cutting rates rapidly in the
financial crisis in late 2008, the fed funds effective rate settled
well away from the target rate on dozens of occasions and didn't
settle once on target from the date of the Lehman Brothers collapse
in mid-September through the end of that year.
Moreover, one byproduct of the Fed's massive stimulus has been a
stifling of daily participation in the fed funds market. To address
that, the Fed's new reverse repo facility is designed to control
cash held by money market funds and mortgage finance agencies that
can't deposit money with the Fed, not just banks.
Recent test results of this facility suggested growing demand for
it, averaging some $200 billion a day.
For now, the Fed is likely to keep its focus on communicating their
take on the economy and by extension when rates might start rising.
A formal decision on how to execute it may still be many months
away.
"You don't want to make any dramatic changes when you are still
feeling your way around. The Fed has been comfortable using the fed
funds rate. They could use it at least symbolically," TD's Mulraine
said.
(Additional reporting by Ann Saphir. Editing by Dan Burns and John
Pickering)
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